A transition with Chinese characters

Investors should expect China to continue to make headlines, but remain focused on the long-term growth prospects of China
and Chinese companies.

IN BRIEF

The Chinese economy is slowing as it makes the transition from investment and industry-led growth to an economy more dependent upon consumption and services. This transition is both needed and an evolving reality.

Although China has been engineering a smooth transition, the risks of a policy mistake have increased. The Chinese government, however, has many tools to manage this transition.

Internationalizing China’s financial system has important consequences for global financial markets.

A slower rate of growth in China is a headwind for emerging markets, but not necessarily for developed markets.

Investors are more worried about the economy than markets

Concerns about China spooked markets in 2015 and again this year when Chinese equities fell 10% within the first week of 2016. Stock market volatility within China can spur volatility around the world, something investors were reminded of in early January. The August devaluation of the yuan, together with the January suspension of trading on stock exchanges, raised doubts about China’s commitment to reform. Despite the headline-making stock market moves, the most pervasive fear still seems to be that Chinese economic growth will plunge, knocking the world into recession—a so-called hard landing for China. In a soft landing, Chinese growth would slow at a measured pace. Underscoring investor fears are rising doubts about the ability of Chinese policymakers to engineer a transition, as highlighted in the most recent market turmoil when concerns over policy changes prompted the equity selloff. When investors do not have a particularly good understanding of China’s economy, the data are opaque, and the economy is changing dramatically, how should investors think about China?

Investment implications

China’s economy is slowing and official statistics likely understate the extent of the slowdown. However, we do not see a hard landing on the horizon for China. We think the authorities can likely manage the economy’s transition, given the reforms that are already in place, the tools policymakers can deploy and China’s continued internationalization. China has low external vulnerabilities, limiting the potential knock-on effects of trouble in the Chinese economy, especially since a gradual slowdown in China is our base case. Still, a slowing China does mean a slower global growth environment. Investors should be aware that China’s importance to the global investing world will only increase after its currency is included in the IMF’s SDR basket and if China opens its capital account further.

The winners and losers from China’s transition are likely to be, respectively, developed and developing economies. Developed markets are likely to see lower prices and higher volatility. In the long run, relatively weak export links and developments favoring their own domestic demand should limit any negative impact on developed markets from China’s transition.

It is a far more differentiated story for emerging markets. Commodity exporters will continue to face headwinds as the industrial sector in China slows and commodity prices remain depressed. However, some manufacturing-oriented emerging markets could benefit in the long-term as a rising middle class and increased consumer spending in China raises domestic consumption and global manufacturers move their factories to countries with lower labor costs in the coming decades. Overall, investors should expect China to continue to make headlines, but remain focused on the long-term growth prospects of China and Chinese companies. Finally, investors should not overlook the investment opportunities in Chinese markets themselves. Here we would focus on China’s new economy and utilize a high degree of selectivity.

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